Last Thursday, in his speech accompanying the country’s 2010 budget, Canadian Finance Minister Jim Flaherty said: “We are building Canada’s reputation as an investment-friendly country.” And to well-deserved accolades, Budget 2010 did indeed finally remove the arcane “Section 116” taxes that have been a perennial thorn in the side of Canadian entrepreneurs trying to entice venture capitalists and other investors from outside Canada to invest in their businesses.

But a little-noticed provision in Budget 2010 completely overwhelms the benefits of eliminating Section 116 taxes. Budget 2010 proposes to instantaneously tax any employee that exercises stock options – at the moment of exercise – and to require the employer to “withhold” the associated taxes, even though the employer has nodirect funds to withhold or pay such taxes – all of which are being levied on “deemed” – but unrealized – income. There is no cash being received anywhere in the process of exercising options, but a whopping tax bill is being levied on the “nothing”.

Next step: Annual taxation of unrealized appreciation in evertyone’s investment portfolio? Seems inconceivable. Yet this is the slippery slope that Canada has embarked upon, as this is precisely what these proposed rules do to employees.

In fairness, Budget 2010 also addressed some of the past inequities in the taxation of stock options in Canada with retroactive relief to harmed employees, and it closed a loophole in the Income Tax Act that permitted double dipping by employees and employers – as well it should have.

But make no mistake, Budget 2010 makes us wildly less “investment-friendly”, to use Mr. Flaherty’s words.

As an illustration of the dire consequences of the proposed new changes in stock option taxation, we have had to halt the IPO process for a very successful Canadian technology company. Under the proposed new rules, if all 300+ employees exercised all of their vested options at once, post-IPO, the company would have an immediate withholding tax liability of about $20million. This is a new, open-ended and completely uncontrollable contingent liability. If we happened to get “irrationally exuberant” technology markets again,the liability could be multiples of $20 million.

All of this flows from a fundamentally flawed and misguided philosophy around the taxation of stock options in Canada. There is no recognition that employee ownership is a proven Good Thing in the motivation of employees and the development of early-stage companies. Employees are deemed to have windfall – and taxable – profits when they exercise stock options, when in fact, all they are doing is preserving their existing ownership stake in the business, rather than selling anything. And most perverse of all, these deemed profits are taxed as “employment income”, while any subsequent losses in the event of a decline in their employer’s share price are treated as capital losses, so that employees can and often are effectively taxed at rates of 100% or even infinite rates on “profits” or sales of shares that they never see.

Budget 2010 exacerbates these perverse rules by demanding a withholding tax from the employer when an employee exercises his options. It is silent on how an employer is supposed to come up with these non-existent funds, or on how or why an employee – that may be subject to lock-ups or blackouts – is supposed to sell enough shares to cover the tax on these mythical profits.

As in the past, we can avoid all of these tax policy problems of tax on unrealized income if we do the ‘typical Canadian thing’, and just stay private for a while longer, and then sell out to a foreign multinational. But then Canada would lose yet another opportunity to have a global company with Canadian headquarters. It is high time that this Government fixes the problem – at its roots – once and for all.

The root of the problems (and of the past acknowledgedinequities that Budget 2010 had to address retroactively) is that the tax treatment of stock option “gains” needs to be symmetrical with the treatment of subsequent share price losses, and taxes need to be levied only on realized net gains. This is not seeking special treatment; rather, this is no different than every other asset class from art to real estate to stock purchase warrants or other securities – or even founding shareholders of the company, or partners in professional firms – none of whom are taxed on the unrealized appreciation in the value of their ownership positions. Nowhere else in the tax system do people get taxed differently on gains and losses with no ability to offset losses against gains – let alone taxed on unrealized income in the first place. Why do “employees” deserve to be singled out for this draconian and patently unfair treatment?

Stock options – and the associated employee ownership – are an absolutely fundamental, powerful economic tool for driving innovation and prosperity in this country. Start-up technology company employees work extraordinarily long hours – for the thrill of creating something special and “game-changing” – but also to share in the economic rewards.

But for option programs to achieve their motivational benefits and potential, they must be fair, they must be simple for all employees to understand (even if you don’t have a degree in accounting), they must not arbitrarily force employees to reduce their ownership in the business simply to pay taxes on unrealized incomeand they must be reasonably easy for the employer to administer.

Here’s the employee’s perspective, as per Budget 2010: Jane, with an option to purchase 50,000 shares at $2.00 that was granted 5 years ago and is now about to expire, has to go to the bank, family or wherever they can to scrape together $100,000. After exercise, she owns 50,000 shares with precisely the same economic value of the options the day before, plus the $100,000 that she has now invested. Where is the realized “income” or “gain” in that? Yet, under the new proposals, if the share value at the time of exercise is (say) $12, she ALSO immediately owes CRA about $110,000. So the cost of exercising her options – just to maintain her existing ownership stake in the business – has more than doubled! And that is supposed to be motivational?

It is even worse in many respects for private companies, because in the example above, if her employer were to subsequently fail, she would not only lose the $100,000 she invested on exercising the options, but she would be permanently on the hook for $110,000 in “taxes” to CRA – without ever having had the opportunity to sell a single share.

So Mr. Flaherty’s claims that we are becoming increasingly “investment-friendly” are bogus, the 116 fix notwithstanding. Investors will see these draconian tax policies and recognize that rather than options being the powerful motivational tool that they were intended to be, Canadian tax policy turns them into the Sword of Damocles over the employees’ heads – most of whom are ill-equipped to understand the nuances of tax jargon and contingent liabilities. All the employees want to do is own – and retain – a stake in their business, just the way the founders and investors get to do – until it is time to sell. Everyone is happy to pay their fair share of taxes – when they sell. But investors with a choice of investing in a properly motivated workforce South of the border, or a demoralized – and even terrorized – one North of the border, will choose accordingly.

Symmetry of treatment up and down, and taxation onlyon realized net gains – like everything else that moves and gets taxed in this country – solves everything. It’s really quite simple. And it’s the only thing that’s even close to fair. And most of all, that is critical to fostering equity capital formation in Canada’s struggling technology sector. As a side benefit, fair tax policy would, like RRSPs, even create a nice legacy of future tax revenues for the country as employee shares continue to grow in value and someday get sold!

Budget 2010 goes the other way, and enhances its pre-existing flawed option tax policies with a withholding tax sledgehammer, in the process shutting down entrepreneurs’ access to equity capital in more ways than can be imagined.

In your example about Jane above with the option to purchase for $2, why wouldn't she just exercise the option and sell when the market price is $12. she could even just sell enough to cover her tax liability. I think if you try and thnk a bit more creatively you can come up with an easy scenario where she can make money out of the deal and still retain some ownership in the company. Stock options are not ownershp until they are exercised.